Examining the Federal Reserve and Rising Rates
It should be understood that the Fed is 100% trying to get you fired! Fed Chairman Jerome Powell himself even stated, “We certainly haven’t given up the idea that we can have a relatively modest increase in unemployment. Nonetheless, we need to complete this task.” The Fed is trying to reduce inflation by reducing the amount of money in the system. They're doing this by reducing consumer spending and demand. One sure way to do this is to get you fired. If you’re fired, guess what? You’re probably not going to spend a bunch of money. You might even try to lower your rent or move back in with your family. Whatever it is, no job equals lower consumer spending, hence, the Fed wants you fired!
Not YOU specifically, of course, but you in the broader sense that you are a contributing, employed member of society that is consuming goods and services; this is the YOU they want fired. It’s not all of you, just some of you. Enough of you that consumer spending will be dampened down to the point that prices are reduced. If you don’t believe me, just look at the data the Fed is watching. It's looking at non-farm payrolls, i.e., how many people are getting jobs. If this number is high, guess what? The Fed is more likely to hike rates. It's looking at the unemployment number, if this number remains low, guess what? It is more likely to hike rates. When enough people no longer get jobs (a drop in non-farm payrolls), or when enough people get fired (unemployment goes up), at that point, it might slow the hikes. Why are they doing this? Well, let’s examine that question.
Supply-Side Issue
First off, the Fed is trying to fix a supply-side problem using a demand-side tool. A great friend of mine once said, “when you’re a hammer, everything is a nail.” The only problem with this is that the U.S. consumer is the one getting hammered. A larger issue with the current inflation problem is driven by supply-side economics. Ships stuck in canals or harbors, not enough ships to begin with, factory shutdowns, China shutdowns, supply-chain issues, all of these are supply-side issues. These factors are massive contributors to inflation. All of these supply-side issues are what’s known as a supply-side shock. Figure 1 shows a graphical representation of this.
The ideal fix for a supply-side shock is simple: increase supply. However, the Fed is under the impression it can’t do this (remember: hammer and nail). Its solution is to shift the demand curve down, by taking away your money and your job. As far as the Fed is concerned, if you lose your money and job, then you no longer contribute to excess demand and prices will fall, so problem solved. Whileout technically correct, this is very academic and doesn’t consider the individual. What the Fed is doing will work, but not without some significant pain.
So why doesn’t the Fed try something new? Great question. The reason is because the Fed seems stuck in the past and it is focused on using 1930s Keynesian Economics to solve a modern-day problem. Now let’s make one thing clear, John Maynard Keynes is brilliant and amazing and in no way am I discrediting him or his great work. I’m just saying, I’m sure the first beer ever brewed was great and groundbreaking, but we've created some much great beers between now and then.
New Solutions
The Fed needs to stop sticking to an old, dated playbook and it needs to try something new. Now, my man Big Ben Bernanke (“BB”) – a great central banker – really did think outside the box during the great financial crisis. He engaged in quantitative easing (QE) to manipulate the long end of the yield curve. Something innovative at the time given the Fed typically influences the front end of the yield curve or short-term rates. Big BB really applied some great and innovative solutions. By just raising the interest rate to induce pain and stifle demand Powell is not innovative. It’s old, dusty, dated, and painful thinking.
There is even more to the issue in that a demand problem also exists. If you have limited supply, you create a panic, which will increase demand. The result is limited supply and higher demand based on hoarding and fear. Remember the great toilet paper crisis of 2020? Indeed, this is part of the issue the Fed is fighting. It is evident because even after a 300bps increase in rates, consumer spending is still strong, and CPI is still elevated at above 8%. The supply-shock induced demand is similar to why people buy during inflation. In times of inflation, the thought is consumers should buy today because tomorrow it will cost more. With limited supply, the fear is you should buy today as much as you can because it might not be there tomorrow, hence an increase in demand. Figure 2 illustrates this notion.
So, what can the Fed do? Am I just saying, “Hey the Fed is doing it all wrong” and then walking out of the party leaving someone else to find the solution? Not at all. Let’s focus on the issue the Fed needs to tackle. OK, there is a supply-side problem, which is impacting inflation. Let’s not only apply a demand-side solution, let’s also apply a supply-side solution.
The Fed’s current solution is to just raise interest rates to impact demand so fewer people will borrow and spend thus creating less money in the financial system. The problem with this is that the only way to build more factories or ships, or to invest in anything that will help increase supply, is to borrow. While the Fed is increasing interest rates to reduce demand, it is at the same time reducing the incentive to invest in anything that will increase supply. It is reducing the demand to produce. What the Fed must see is that not all interest rates are created equal. I will say that again. Not all interest rates are created equal. If you increase interest rates you would reduce demand, however, if you were to selectively reduce interest rates on borrowing that would lead to future supply development you would encourage supply production and lower prices by lowering rates. Here’s a picture.
One way the Fed could achieve this is to provide zero cost funds to banks that make loans to businesses for purposes that support supply development. The Fed doesn’t need to look at loan applications and see if it’s for business-supply development and then determine what rate the borrower should pay. That’s the exact role of a bank. A bank is a financial intermediary – this is their job. The bank can also access money from the Fed. What I’m proposing is that the Fed provide zero cost funding to banks for the purpose of providing loans for supply development. Guess what happens then? You got it. Businesses will go gangbusters and start to develop supply and then guess what? You got it – supply increases. The result is we will have an economy with strong employment, strong economic development, and lower prices.
The Island & The Fed
I would like to add a quick analogy. Imagine you're on an island and you had enough food to feed 30 people for the next six months, but you had 50 people on the island (how you got into this mess is a story for another time). You would essentially have a bidding war for the food, and the demand for the food would rapidly increase. People would be willing to pay/barter/trade anything for the food. This is the situation the Fed is in today. The Fed’s solution to this shortage is to just eliminate 20 people so supply equals demand. Problem solved as we now only have 30 people and food for 30. We would be, as economists say, in equilibrium. This might be equilibrium and it might be nice for the lucky 30 people, but this is not an ideal situation for the 20 people who were eliminated off the island (let's just say they were voted off). If we were to instead, Oh, I don't know say, plant more food, we could fix the supply-side issue and feed everyone. At that point all 50 people could eat. This is what the Fed needs to do, its needs to let everyone eat.
To sum it up, the Fed is the hammer so everything is a nail. They need to apply updated logic to tackle the issue of inflation. Given not all rates are created equal, one unconventional approach would be to lower select rates to reduce inflation (so many economists just had a spasm) – again, this is a supply-side solution. I’m not saying stop raising rates. Raising rates will, indeed, reduce demand, but let’s reduce selective demand while still allowing people to work and flourish.